MPT's Revenge

You're hot then you're cold
You're yes then you're no
You're in then you're out
You're up then you're down

- Katy Perry

This pop star's comments may well describe many investors'
activities over the last several months - to their own detriment.
Most agree a long-term approach is correct, but what is long-term,
anyway?

Modern Portfolio Theory (MPT) is effectively the basis for every
finance graduate program in the country and has been since its
formulation in the 1970s. An accumulation of fancy Greek symbols
and seemingly rational concepts, MPT is a tool used to create an
optimal portfolio given a market's and investor's constraints.

Because investments tend to have correlations less than 1.0, we can
theoretically build an optimal portfolio that, through
diversification, will return a maximum amount over time for a given
level of risk tolerance. Even tools such as leverage can be
included in these formulations.

An underlying theme is that investors should look to the long term
for returns, focusing little on the market's wiggles and waggles.
Unfortunately, what constitutes a wiggle or waggle is left for the
market to determine. Is a three-year downturn a wiggle or is it a
substantive event demanding a change in formula inputs? How about a
10-year downturn as the stock market recently reflected?

Also, note the assumption that correlations are less than 1.0.
After last September's events (and even during times leading up to
them), many correlations moved very close to 1.0. This created a
perfect storm of falling investment prices, which in turn led to
further investment losses as investors panicked and sold, moving to
"cash" or money market mutual funds.

For years leading up to this crisis, total investments in money
market funds hovered around $2 trillion. Today, we are around $3.5
trillion. As these extra funds work their way back into the system,
investment prices must necessarily rise. This is what we are seeing
today.

The S&P 500 is up 55 percent since its March 9 trough with
other risk markets following along. Even commodities continue their
rally with gold reaching a new recent high of over $1000 per ounce
last Friday.

Record new issuance of Treasury securities at rock-bottom rates
continues to attract solid demand as investors shift from "cash" to
"anything with yield." Are investors really buying 30-year
Treasuries at 4.18 percent for value? Will they hold them for 30
years?

According to the Investment Company Institute (ICI), over $56
billion has flowed into stock mutual funds since April. On a
comparative basis, this is about a 0.5 percent increase in total
funds invested in the stock market. As a trend, pure buying power
could easily continue to outweigh historical valuation techniques,
fueling a stock market rally (bubble?) even as the economy
continues to languish. The same is possible in all other risk or
even Treasury markets.

Some have argued MPT is dead, but perhaps we just have to redefine
our wiggles and waggles.

At the end of the day, fish have to swim and investors have to
invest. The sidelines are no place for professionals.

Key Developments

Consumer credit outstanding declined by a record -$21.6 billion in
July after falling $15.5 billion in June. The current six-month
decline is the longest losing streak since the credit crunch in
1991. It is clear consumers will have to fund activity going
forward in a more rational and less levered manner than in the
past.

Consumer sentiment measured by the University of Michigan's index
increased to 70.2 in September from 65.7 in August. Though off the
lows of the mid-50s, consumer sentiment has a long way to go to get
back to the 90 area experienced a little over two years ago. Given
consumption drives the American economy, it is safe to say activity
in this post-recessionary period will be tepid at best.

You're hot then you're cold You're yes then you're no You're in then you're out You're up then you're down

- Katy Perry

This pop star's comments may well describe many investors'activities over the last several months - to their own detriment.Most agree a long-term approach is correct, but what is long-term,anyway?

Modern Portfolio Theory (MPT) is effectively the basis for everyfinance graduate program in the country and has been since itsformulation in the 1970s. An accumulation of fancy Greek symbolsand seemingly rational concepts, MPT is a tool used to create anoptimal portfolio given a market's and investor's constraints.

Because investments tend to have correlations less than 1.0, we cantheoretically build an optimal portfolio that, throughdiversification, will return a maximum amount over time for a givenlevel of risk tolerance. Even tools such as leverage can beincluded in these formulations.

An underlying theme is that investors should look to the long termfor returns, focusing little on the market's wiggles and waggles.Unfortunately, what constitutes a wiggle or waggle is left for themarket to determine....Read More